Scary. But just how scary? Chinese foreign asset growth and hot money flows

The foreign assets of China’s government are clearly growing very fast. The $75 billion increase in April’s reserves — more like $82 billion after adjusting for the fall in the value of China’s existing euros — suggests a very very strong underlying pace of growth. But the reserves data jumps around. A lot.

The most plausible explanation for the fall in late 2007, for example, is that China channeled a lot of the rise in its foreign assets into the banks and the CIC. The same applies to say a month like March. Headline reserve growth was very low — likely because the banks were asked to meet the rise in their reserve requirement by holding dollars and the transfer of a large chunk of change to the CIC.

In the following chart, I added in estimates of the various ways China likely has stashed funds away — the rise in bank reserve requirements, the CIC — to my previous estimates of China’s foreign asset growth. My estimates for the rise in bank reserves come from Logan Wright, and my estimate of the timing of transfers to the CIC are similar to Logan’s estimates. All this suggests — if this is the right interpretation of the data — that the underlying pace of Chinese foreign asset growth jumped to around $225 billion a quarter in q1 2008.

Not surprisingly, a chart showing the the 12m increase in China’s foreign assets (adjusting for valuation effects) shows rapid growth.

Wang Tao, now chief China economist at UBS, estimates these may have subtracted anywhere up to $US224 billion from last year’s official foreign exchange numbers. That would mean China’s actual foreign exchange inflows tripled.

My estimates are — not surprisingly, as I admire Wang Tao’s work — similar.

If Chinese foreign asset growth stabilizes at its q1 level (and if my estimates for q1 foreign asset growth are close to right), annual Chinese foreign asset growth would stabilize at around $900 billion. That is huge.

And as of now, there isn’t much evidence of stabilization. The underlying trend is up.

No wonder outsideobservers — and I would hope, Chinese policy makers — are scared.

There isn’t much evidence though that Chinese policy makers are prepared to contemplate the kind of policy actions that might dramatically reduce incentives for hot money to come into China. Cutting policy interest rates to US levels, for example, would help. But it would also fan inflation. Allowing the RMB to appreciate to the point where investors no longer expected further appreciation would help reduce the incentive to move money into China. But that seems unacceptable to China’s export sector.

China is increasingly boxed in, with no good choices. And its policy response, at least to me, seems to consist of fiddling around the edges — tightening controls on inflows, loosening controls on outflows, seeing if a slower pace of RMB appreciation helps — and hoping underlying conditions change. That approach is precisely the approach that got China into its current predicament.

Right now there is little doubt that capital inflows — FDI and hot money flows, with some hot money disguised as FDI — account for the majority of China’s reserve growth. The trade surplus and interest income account for maybe $85 billion of the (conservatively estimated) $300 billion increase in China’s total foreign assets through April. FDI explains another $35 billion. That leaves a huge gap.

A chart that shows implied reserve growth and total foreign asset growth against identified inflows shows the scale of hot money inflows right now. The gap between identified sources of inflows and overall reserves and foreign asset growth is one measure of hot money.

(One note: the graph is on a rolling 3m basis — so it cannot be directly compared with the year-to-date numbers above)

China’s government isn’t just subsidizing its exporters; it is also offering close to free money to anyone who can get money into China.

If — as Logan Wright, Wang Tao, Michael Pettis, I and no doubt others believe — China’s stated reserve growth significantly understates the “true” increase in the government’s foreign assets, hot money flows are not just are accelerating. Consider a graph showing the “hot money flows” implied by the chart showing the 12m growth in China’s foreign assets.

This doesn’t look sustainable. Not to me.

Opinions expressed on CFR blogs are solely those of the author or commenter, not of CFR, which takes no institutional positions.

31 Comments

Posted by Mike PJune 3, 2008 at 4:35 pm

Brad – Perhaps you’ve done this in former posts, but I wonder if you could expand on the point you made in the last sentence – namely, “anyone who can get money into China.” Who is that? That is, what types of capital control restrictions does China have right now? And if those capital controls are de jure far-reaching, how are so many big investors getting around them??
Perhaps a stupid question.

Brad, let me get this straight:
1. China makes stuff and send them to the US for dollars
2. in order to keep the RMB artificially down (for greed, that is) the PBoC turns the dollars into truckloads of treasuries and agencies
3. thanks to all this undeserved financing the FED (for greed) engineer the biggest debt bubble of all times
4. Joe6Pack buys the Chinese toys on credit thanks to the housing bubble and the easy credit
5. the only one making real money out of all of this scam are the very rich in the US (expecially the bankers servicing the debt) who now…
6. are greedly moving their hot money to China speculating on the inevitable RMB appreciation
7. probably buying the sterilization bills that PBoC needs to issue to counter their same speculation

I bet George Orwell though something like that for a novel, but ditched it because it sounded too unrealistic.

Posted by bsetserJune 3, 2008 at 6:28 pm

Mike P (and Alessandro) — I don’t think the big money managers in the US or Europe have found ways around the controls. If you care about liquidity it is hard to move money into China. Not to speak impossible to do so in large volumes. The offshore market — where one hedge fund bets against another hedge fund about the pace of RMB appreciation — is active. But i don’t think big offshore players can buy say Chinese government debt. In that sense, China’s controls are still effective — China has been able to maintain higher domestic interest rates than the US.

The inflows come from overstated FDI. From overstated exports (tho tis hard to know by how much, and i think most of China’s trade surplus is real). and from Chinese citizens with funds abroad and the Chinese diaspora steadily moving the maximum amount they can into China.

And then Chinese citizens with dollar deposits are shifting into RMB — and Chinese firms that can borrow abroad (or domestically) in dollars are doing so.

I think this is more a lot of smaller players voting with their feet than a massive “attack” by offshore funds.

On Pettis’ blog he reports DBank’s research on the sources of inflows; I cannot add much to what they found.

Mike P: That is, what types of capital control restrictions does China have right now?

The big capital control is that the RMB is not tradable on the capital account which means that if you want to convert RMB to dollars, you have to have a receipt showing that you got the RMB by doing some export or import business.

The capital controls work to keep RMB from leaving China, but they aren’t effective at all at keeping dollars from coming into China. All of them were designed in an era when the dollar was considered “hard currency” and the goal was to keep people from turning local currency into dollars.

Mike P: And if those capital controls are de jure far-reaching, how are so many big investors getting around them??

It’s actually quite easy. I plan to build a huge factory in China and naturally I’ll need lots and lots of RMB to pay construction workers etc. So I get all of the permissions to exchange dollars into RMB.

Then I look for any excuse I can to keep the RMB in the bank account and delay paying out RMB for as long as possible.

One thing that you have to be careful there is double counting. The other thing that you have to be careful about is “telephone game.”

If you think that the reserve numbers are high, it’s tempting to take a number and then add something to it. Someone gives you a low, middle, and high estimate, and you think the high estimate is correct so that becomes your medium.

If it goes through three or four people that are doing exactly the same thing then pretty soon you get extremely high numbers that are out of touch with reality.

bsetser: China is increasingly boxed in, with no good choices.

So what are the bad ones? Remember that not making a choice is a choice.

bsetser: I don’t think the big money managers in the US or Europe have found ways around the controls.

I think they have. Invest in a Chinese company, build a Chinese factory, etc… Anything that moves US dollars into China gets around the controls. The amounts that are moving into China are simply too large to be “mom and pop” numbers.

bsetser: If you care about liquidity it is hard to move money into China.

It’s trivial to move money into China. Getting it out is a bit harder.

bsetser: The inflows come from overstated FDI.

Or correctly stated FDI.

That RMB$15 million that someone moved in to build a factory. Well, we really do plan to build that factory and spend that RMB$15 million. But we aren’t just quite ready yet. You see, we really can’t decide whether the carpet should be blue or yellow. But we’ll spend that money as soon as we make a decision. Too bad that money is just sitting in that bank account appreciating. I think I like a blue carpet. Now we have to decide where to put the corporate logo. Decisions. Decisions. Decisions.

You will note that everyone seems to be moving money in, but no one seems to be starting new projects….. Hmmmm…..

Posted by bsetserJune 3, 2008 at 11:20 pm

2fish — you are right in a sense; if you expect the RMB to appreciate you want to move funds into China sooner, and delay moving funds out even if you can.

Three small points:

One; setting up a factory is a lot harder than buying a security – and given that fDI only explains $35b of the increase in China’s foreign assets, this doesn’t seem to be the dominant channel funds are using to enter China. I also know of far more players in the NDF market (where both sides of the trade are offshore) rather than players in the move money into china market — but i suspect you have more info on that market than i do.

Two; China has made it much easier for Chinese residents to move funds out; the problem is a lack of desire not a lack of opportunity. Look at the outflows from domestic dollar denominated bank accounts …

Three. I agree that there is a risk of overstating numbers. ADIA’s size is a classic example. Morgan Stanley used $875b, others picked it up and soon it is the standard estimate — I personally think it is too high, as does Mohsin Khan of the IMF, Landon Thomas of the NY and Gerald Lyons of standard chartered. It still gets used .. and absent a definitive statement from ADIA, who really knows. That said, I have been conservative in my estimates for China’s foreign asset growth this year. I could easily argue that China’s foreign assets have increased by $350b not $300b so far this year — $200b in valuation adjusted reserves, $90b to the CIC this year and $60b in bank fx reserves. the $300b number i used above is in that sense conservative. Moreover, i refrained from estimating q1 foreign asset growth at over $200b even though that was what I suspected until the April fx number came out. Now it is totally possible I am still overstating foreign asset growth — if so, the PBoC or someone else should release detailed data on the banks fx balance sheet and the scale of funds transfered to the CIC. THat would settle this all fairly quickly.

And if I am off, I would be very happy if someone pointed out how and why — my assumptions (Along with those of Logan Wright and Wang Tao) have been published.

bsetser: One; setting up a factory is a lot harder than buying a security

Yes, but if you can’t buy a security….

bsetser: given that fDI only explains $35b of the increase in China’s foreign assets

The $35 billion is the tip of the iceberg. Once a company gets authorization to transfer money over for capital expenses, then the can also transfer money over for other things. The $35 billion also doesn’t count repatriation of US dollars by Chinese companies.

bsetser: my assumptions (Along with those of Logan Wright and Wang Tao) have been published.

As far as I can tell, $74 billion comes unsourced from a Reuters article and it isn’t clear what it includes and what it doesn’t include. You can see the number escalation people are quoting each other and adding more to the mix. (It’s actually pretty funny to read something in Reuters get reprinted in the China Post, at which point it gets reprinted as coming from “state media.”)

The reason I’m skeptical of some of these numbers it that there are only so many places you can hide a $350 billion elephant. If China did have that much in inflows in three months, there must have been some massive outflows and investment somewhere.

Posted by CICRJune 4, 2008 at 12:43 am

I missed the scary part.

Posted by bsetserJune 4, 2008 at 12:52 am

2fish — if it helps, china business news has published a similar number for April. China only formally releases data at the end of the quarter, so all the monthly data comes from informal leaks. Some of those leaks are semi-official, and they generally have been quite accurate. and, like i said, if china wants to prove us reserve growth speculators wrong, it could follow the example of india or thailand or russia and release weekly reserves data.

your point about the difficulties hiding a $350 b elephant is a good one — i too like to try to match debtor and creditor data, and see the flow from both sides. the fact that the fed’s custodial account rose by $60b (or close) in march and april consequently is central to my thinking. I think we have found a good chunk of the $350b elephant right there.

FRBNY’s custodial accounts haven’t been growing as fast in may — which suggests either a slowdown in chinese reserve growth after rMB appreciation slowed or the awarding of investment mandates by the CIC, which would shift some of the cHina’s foreign assets out of official and into private hands.

There are huge uncertainties here. I hope I have always acknowledged that. At the same time, a lot of those uncertainties could be reduced if China were a bit more transparent, if London collected a bit more BoP data (even if this scared off some tax-evading types and some super-secretive sovereign types) and if the US TIC data was a little bit more timely and a bit more accurate ….

the reality is that about seven institutions (PBoC/ SAFE, CIC, SAMA (Saudi Arabia), CBR (Russia), Norges bank investement management, KIA and ADIA account for a truely extraordinary amount of the monthly global capital flow right now, and if those seven institutions revealed more information, there wouldn’t be much doubt.

there are no technical barriers to getting better data. seven institutions are easy to survey. the problem is that those institutions don’t want the world to know what they are up to.

Posted by bsetserJune 4, 2008 at 1:01 am

“scary” was a reference to uber-blogger Yves Smith’s post on Chinese foreign asset growth. And more generally, the scary bit is accelerating growth in an already large number – and the plausible notion that the government of China is on pace to add $ 1 trillion to its foreign assets in a year. I at least find that scary on a number of levels — b/c of the scarily large losses Chinese taxpayers may incur, b/c of the scarily large implied US dependence on China’s willingness to keep on financing the US and b/c of the enormous amounts that this implies China needs to place in global markets.

bsetser: if it helps, china business news has published a similar number for April.

The trouble here is that I’ve found that often newspapers will copy each other stories without citation.

bsetser: the fact that the fed’s custodial account rose by $60b (or close) in march and april consequently is central to my thinking.

A lot of that was the fed releasing massive amounts of funds to broker-dealers. It may be that a lot of those treasuries ended up in China. Also, if this is the case, then the march/april numbers might be one time spikes.

bsetser: There are huge uncertainties here. I hope I have always acknowledged that.

It’s still hard to come up with a $70 billion/month in uncertainty.

bsetser: there are no technical barriers to getting better data. seven institutions are easy to survey. the problem is that those institutions don’t want the world to know what they are up to.

If there only seven institutions, then you can get them all in one conference room, have Bernanke, Paulson, and the head of the ECB, draw the shades, and then have Bernanke ask “ok people, what are you up to?”

Posted by gloryJune 4, 2008 at 6:51 am

OT, but would you speculate that a ‘grand bargain’ has been struck between bernanke (via paulson) and the GCC? i.e. we won’t cut anymore if you won’t depeg?

Agreed, there were specialist companies offering to set up “companies” for foreigners new to China posting their ads and services on all the expat sites, same for those specialists in the property sector . Bit dodgy. Problem is , speculation has split effectively into 2 ; amongst those in China (natives or foreigners)the rush for investment in anything or everything that offers some yield, and those outside China who Setser has quite correctly pointed out have been betting on appreciation of the yuan, ETNs and almost everything that gives them notional exposure to the China boom. The latter probably won’t have much impact on the mainland but it’s the former who’ll have some difficulty getting the cash out of china if need be, wonder if anyone consider this aspect of the hot potato?

Totally agree on the difficulty of getting money out, can you imagine some investor getting “agents” to travel out with bags of money – max US$50,000 per annum right? Or waiting interminably for that transfer and that’s after all that paperwork and redtape. Foreigners dealing in the art market (think auctions) have been known to keep rmb cash in safe deposit boxes waiting for that 50% appreciation – kid you not

Posted by bsetserJune 4, 2008 at 8:49 am

2fish — the changes in the composition of the Fed’s balance sheet wouldn’t explain the rise in the Fed’s custodial holdings for other central banks. The only ways the custodial holdings can rise are a) if a central bank moves some of its existing treasury and agency holdings to the fed or b) if a central bank buys a lot of treasuries and agencies and transfers them to the fed for safekeeping. The very rapid rise in custodial holdings in March and April consequently is VERY strong evidence of rapid growth in some central banks reserves.

Judy — your intuition is right. Implied hot money flows are the difference between my estimate for official asset growth and known sources of inflows. I also calculate the hot money flows implied if China’s reserves data captures all of its official asset growth — i.e. if nether the CIC nor the state banks are adding to their foreign assets. THat is the gap between reserve growth and known sources of inflows.

Fascinating work Brad. Michael Pettis said I should refer this question to you:

Just because the total value of foreign asset growth is being QUOTED in dollars, doesn’t necessarily mean the assets being accumulated actually ARE dollars/dollar-denominated, correct? Or does it?

If not, is there any way to know which currencies China is raking in?
The trade surplus with the U.S. is shoveling dollars their way, but does anyone know what currencies are flowing inbound as part of these ambiguous “hot money” flows?

If they are in dollars, seems like you could reasonably claim a new dollar carry trade is emerging.

Posted by bsetserJune 4, 2008 at 10:47 am

Glory. I would be surprised if Paulson cut such a grand bargain (with Bernanke’s permission); it would imply giving the Gulf sheiks a veto over US monetary policy, which is something the US should never do (IMHO). Paulson may have noted that the US is worried about inflation, sees risks as more balanced, etc. I think the bargain is a bit different — you keep the peg, and I’ll keep the US open to investment from the Gulf (and perhaps a bit of you don’t really want euros at the current price anyway, especially given how rigid their labor markets are …)

Posted by bsetserJune 4, 2008 at 10:52 am

Rolfe — I think most of the funds moving in are coming from the overseas Chinese community or those with ties to them, and i suspect those moving funds into China are reducing their dollar holdings, so yes, it has the character of a $ funded carry trade.

China tend to intervene mostly in the $/ RMB — so in the first instance it takes in $. My own work suggests it holds mostly but not entirely dollars. the latest US data is consistent with a $ share of China’s portfolio in the 65 to 70% range — but the US data may not be catching all of China’s holdings. If i had to bet i would bet that China still holds close to 70% of its Reserve/ CIC assets in dollars.

incidentally, China runs a very large trade surplus with Europe these days. that implies European importers sell euros to buy dollars — which are then traded for Chinese goods (most of China’s trade is invoiced in dollars). Chinese exporters sell $ for RMB — and the Chinese central bank then sells some of the $ it takes in for euros. On net tho, i would suspect there is a flow out of Europe to China that supports Chinese purchases of US assets.

My estimates suggest that Chinese purchases of US assets are now roughly twice as large as China’s trade surplus with the US, so there are additional flows into China that are supporting Chinese financing of the US.

hope this makes sense.

Posted by dmg555June 4, 2008 at 12:12 pm

Brad
A suggestion for a future blog: Lots of economists use the term inflation rather loosely. From my monetarist Milton Friedman position, inflation is simply the amount of money in the money supply. It is not baskets of goods and services that are massaged by hedonic changes and seasonal adjustments that try to approximate the relative value of technological changes within that basket of products and services. Yes CPI does indicate inflationary trends but it is the residual effect of monetary changes.

So this brings me to the question: How, in this complicated world of central bank manipulative policy, do we approximate the amount of money in the money supply? In older times, governments just turned on the printing press, to use a phrase, but these days we don’t have a printing press gauge any more. We can’t put a spy outside of the money factory and watch how many monetary units are being added. With the Fed buying, selling, and borrowing a whole new variety of financial instruments it’s hard to really follow the money (hat tip).

The gentlemen from Shadow Statistics, John Williams, calculates M1,M2 and M3 figures the old fashion way and his work suggests that monetary growth is substantially higher than governmental figures would have us believe.

How does one accurately estimate money supply growth of the US dollar ( and in essence true US inflation) within a globalized world?

Posted by donJune 4, 2008 at 5:48 pm

Brad –
I wonder how much ‘hot money’ might be coming from Japan. After all, they’ve had experience with circumventing capital controls designed to protect a dramatically undervalued currency back when the yen was kept at 250 per dollar. This might also help explain how the yen has maintained its current low value – I think stocks should already have adjusted to the initial carry-trade outflows (current outflows should be cancelled by large inflows as earlier outflows are returned).

quote: I think most of the funds moving in are coming from the overseas Chinese community or those with ties to them.

I don’t. There are about 40 million overseas Chinese, and a $70 billion inflow means that on the average each overseas Chinese deposited about over a thousand dollars into the PRC last month. I didn’t do anything like this and neither did anyone else that I know, and you don’t see any particular signs of massive deposits from the overseas Chinese news media.

The amounts involved are just too large for the diaspora.

dmg555: How, in this complicated world of central bank manipulative policy, do we approximate the amount of money in the money supply.

First we need to define what money is, and that’s much harder than it first seems. Money is like gravity, it’s something that you run into so often that people just don’t think deeply about what it is, and the more you think about it weirder and more mysterious it is.

dmg555: In older times, governments just turned on the printing press, to use a phrase, but these days we don’t have a printing press gauge any more.

Actually there is. Look at the Federal Reserve’s balance sheet and that tells you how much paper money there is out there in the world. It turns out that there is only about $900 billion in US paper money out in the world.

Posted by bsetserJune 4, 2008 at 7:23 pm

2fish — the unexplained inflow for april is more like $50b rather than $70b but your math is still compelling –

I would note two other sources of pressure:

a) Chinese firms borrowing abroad and moving funds back
b)Chinese households shifting out of domestic dollar deposits (or putting $ under the mattress in the bank)

all told tho it is hard to see exactly how so much money is coming in …

the bets i see on China based in new york are, as Judy Yeo notes, proxy bets — but relying on what your hear of directly isn’t an accurate guide to what is going on.

Posted by NickJune 4, 2008 at 7:33 pm

Admittedly I’m very naive when it comes to global monetary flows, but I have a question for the learned folks. It seems obvious to me that China is accumulating dollars, and in-part funding America’s continued deficit consumption through the trade deficit. I would also guess international investors (including Americans) are moving money into China’s currency and business as investments and a hedge against US currency devaluation.

In the long-term this is bad for the US because China, in theory, would be able to buy all of our assets with our money, until we have nothing left (although our government would likely step in unilaterally in some way before that). They could also probably cause a currency collapse by selling all their debt on the open market at once, but the international destabilization would hurt everyone.

Assuming neither of the end-game scenarios, what’s the short-term negative for us to their holding trillions of US debt and financing our continued deficit spending? Or is the negative the threat of bigger actions?

Nick — the long-term cost is first the interest that has to be paid on the debt, and second the growing set of risks that this relationship is unstable. the fact that China isn’t getting compensated for the risks it is taking reduces the interest cost, but it — at least in my view — adds to the risk of a destablizing break.

The other cost comes from the changes in the composition of output that accompany the rise in Chinese financing. the combination of easy access to debt and the difficulties competing against production in China encourages investment in the non-tradeables sector and discourages investment in tradeables. yet over time, unless the US can run up its debts for ever, it needs to export more or import less — so it needs more investment in tradables. The longer the current situation persists, in my view, the more difficult the ultimate adjustment back to an economy that pays for its imports with real exports rather than the export of IOUs.

the frictionless costless movement of resources between sectors in most economic models doesn’t match my sense of how the world works.

Posted by dmg555June 5, 2008 at 5:29 pm

twofish: thanks for the reference on the paper money thats a start. The next part what is money, is a bit more complicated. I’m in the midst of The international Monetary (non)order and the “global Capital Flows Paradox” by Jorg Bibow which is a terrific paper and can be picked up on Michael Pettis’s 6/5 post. I look forward to your thoughts on the deeper question.

Posted by RealistJune 5, 2008 at 9:48 pm

“it would imply giving the Gulf sheiks a veto over US monetary policy, which is something the US should never do (IMHO).”

Saudi Arabia’s Shura council (parliament) will hold a series of meetings over the next two weeks to discuss a controversial proposal by a key member to curb oil production to save reserves for better prices, Saudi media reported. The council will listen to a report by deputy chairman of the Shura water and public utilities committee, Salim bin Rashid Al Marri, who will argue for cutting crude supplies to maintain the Kingdom’s underground reserves.
“Marri will seek to persuade council members that the oil production must be linked to the country’s actual development needs not the needs of foreign consumers,” Alriyadh newspaper said in a report from the capital Riyadh. “He will tell the Council that keeping sufficient oil quantities underground is a good investment for the future as oil prices will then be higher…he will argue that this will be better than producing more oil and generating financial surpluses on the grounds these surpluses are causing inflation.”

To understand this move, we should take into account two facts.

First, that, as GWB reminded them on May 18, “The rising price of oil has brought great wealth to some in this region, but the supply of oil is limited, and nations like mine are aggressively developing alternatives to oil.” Which may be translated as: “Keep in mind that just as you will be depleting your finite oil reserves, we will be turning more and more of our crops into biofuels, no matter what happens to people in food importing countries (like yours, BTW).”

Second, the loss of purchasing power of their forex reserves lately in terms of grains, oilseeds, etc., resulting from US monetary policy that – as the US officially states – is not directed in the least to maintaining the purchasing power of the $ in terms of internationally traded goods.

In this scenario, the only logical response that can be expected from countries with big current account surpluses, whose exports come from a finite, non-renewable endowment, and which are – and will always be – heavy food importers, is to cut down their oil exports to just cover their imports, so as not to add any further dollar to their fast-depreciating (in real terms) reserves.